Ugly little cherubs

I am working on my long-term investment strategy, and I keep using the Warren Buffet’s tenets of investment (Hagstrom, Robert G.. The Warren Buffett Way (p. 98). Wiley. Kindle Edition.).

At the same time, one of my strategic goals is coming true, progressively: other people reach out to me and ask whether I would agree to advise them on their investment in the stock market. People see my results, sometimes I talk to them about my investment philosophy, and it seems to catch on.

This is both a blessing and a challenge. My dream, 2 years ago, when I was coming back to the business of regular investing in the stock market, was to create, with time, something like a small investment fund specialized in funding highly innovative, promising start-ups. It looks like that dream is progressively becoming reality. Reality requires realistic and intelligible strategies. I need to phrase out my own experience as regards investment in a manner, which is both understandable and convincing to other people.

As I am thinking about it, I want to articulate my strategy along three logical paths. Firstly, what is the logic in my current portfolio? Why am I holding the investment positions I am holding? Why in these proportions? How have I come to have that particular portfolio? If I can verbally explain the process of my so-far investment, I will know what kind of strategy I have been following up to now. This is the first step, and the next one is to formulate a strategy for the future. In one of my recent updates (Tesla first in line), I briefly introduced my portfolio, such as it was on December 2nd, 2021. Since then, I did some thinking, most of all in reference to the investment philosophy of Warren Buffett, and I made some moves. I came to the conclusion that my portfolio was astride a bit too many stocks, and the whole was somehow baroque. By ‘baroque’ I mean that type of structure, where we can have a horribly ugly little cherub, accompanied by just as ugly a little shepherd, but the whole looks nice due to the presence of a massive golden rim, woven around ugliness.

I made myself an idea of what are the ugly cherubs in my portfolio from December 2nd, and I kicked them out of the picture. In the list below, these entities are marked in slashed bold italic:

>> Tesla (,

>> SA ( ),

>> Alten ( ),

>> Altimmune Inc ( ),

>> Apple Inc ( ),

>> CureVac NV ( ),

>> Deepmatter Group PLC ( ), 

>> FedEx Corp ( ),

>> First Solar Inc ( )

>> Inpost SA ( )

>> Intellia Therapeutics Inc ( )

>> Lucid Group Inc ( )

>> Mercator Medical SA ( )

>> Nucor Corp ( )

>> Oncolytics Biotech Inc ( )

>> Solaredge Technologies Inc ( )

>> Soligenix Inc ( )

>> Vitalhub Corp ( )

>> Whirlpool Corp ( )

>> Biogened ( )

>> Biomaxima ( )

>> CyfrPolsat ( )

>> Emtasia ( )

>> Forposta ( )

>> Gameops ( )

>> HMInvest ( )

>> Ifirma ( )

>> Moderncom ( )

>> PolimexMS ( )

>> Selvita ( )

>> Swissmed ( )  

Why did I put those specific investment positions into the bag labelled ‘ugly little cherubs in the picture’? Here comes a cognitive clash between the investment philosophy I used to have before I started studying in depth that of Warren Buffet and of Berkshire Hathaway. Before, I was using the purely probabilistic approach, according to which the stock market is so unpredictable that my likelihood of failure, on any individual investment, is greater than the likelihood of success, and, therefore, the more I spread my portfolio between different stocks, the less exposed I am to the risk of a complete fuck-up. As I studied the investment philosophy of Warren Buffet, I had great behavioural insights as regards my decisions. Diversifying one’s portfolio is cool, yet it can lead to careless individual choices. If my portfolio is really diversified, each individual position weighs so little that I am tempted to overlook its important features. At the end of the day, I might land with a bag full of potatoes instead of a chest full of gems.

I decided to kick out the superfluous. What did I put in this category? The superfluous investment positions which I kicked out shared some common characteristics, which I reconstructed from the history of the corresponding ‘buy’ orders. Firstly, these were comparatively small positions, hundreds of euros at best. This is one of the lessons by Warren Buffet. Small investments matter little, and they are probably going to stay this way. There is no point in collecting stocks which don’t matter to me. They give is a false sense of security, which is detrimental to the focus on capital gains.  

Secondly, I realized that I bought those ugly little cherubs by affinity to something else, not for their own sake. Two of them, FedEx and Allegro, are in the busines of express delivery. I made a ton of money of their stock, just as on the stock of Deutsche Post, during the trough of the pandemic, where retail distribution went mostly into the ‘online order >> express delivery’ pipeline. It was back then, and then I sold out, and then I thought ‘why not trying the same hack again?’. The ‘why not…?’ question was easy to answer, actually: because times change, and the commodity markets have adapted to the pandemic. FedEx and Allegro has returned to what it used to be: a solid business without much charm to me.  

Four others – Soligenix, Altimmune, CureVac and Oncolytics Biotech – are biotechnological companies. Once again: I made a ton of money in 2020 on biotech companies, because of the pandemic. Now, emotions in the market have settled, and biotech companies are back what they used to be, namely interesting investments endowed with high risk, high potential reward, and a bottomless capacity for burning cash. Those companies are what Tesla used to be a decade ago. I kept a serious position on a few other biotech businesses: Intellia Therapeutics, Biogened, Biomaxima, and Selvita. I want to keep a few of such undug gems in my portfolio, yet too much would be too much.

Thirdly, I had a loss on all of those ugly little cherubs I have just kicked out of my portfolio. Summing up, these were small positions, casually opened without much strategic thinking, and they were bringing me a loss. I could have waited to have a profit, but I preferred to sell them out and to concentrate my capital on the really promising stocks, which I nailed down using the method of intrinsic value. I realized that my portfolio was what it was, one week ago, before I started strategizing consciously, because I had hard times finding balance between two different motivations: running away from the danger of massive loss, on the one hand, and focusing on investments with a true potential for bringing long-term gains.

I focus more specifically on the concept of intrinsic value. Such as Warren Buffet used it, intrinsic value was based on what he called ‘owner’s earnings’ from a business. Owner’s earnings are spread over a window in time corresponding to the risk-free yield on sovereign bonds. The financial statement used for calculating intrinsic value is the cash-flow of the company in question, plus external data as regards average annual yield on sovereign bonds. The basic formula to calculate owner’s earnings goes like: net income after tax + amortization charges – capital expenditures). Once that nailed down, I divide those owner’s earnings by the interest rate on long-term sovereign bonds. For my positions in the US stock market, I use the long-term yield on the US federal bonds, i.e. 1,35% a year. As regards my portfolio in the Polish stock market, I use the yield 3,42% for Polish sovereign bonds on long-term.

I have calculated that intrinsic value for a few of my investments (I mean those I kept in my portfolio), on the basis of their financial results for 2020 and compared it to their market capitalisation. Then, additionally, I did the same calculation based on their published (yet unaudited) cash-flow for Q3 2021. Here are the results I had for Tesla. Net income 2020 $862,00 mln plus amortization charges 2020 $2 322,00 mln minus capital expenditures 2020 $3 132,00 mln equals owner’s earnings 2020 $52,00 mln. Divided by 1,35%, that gives an intrinsic value of $3 851,85 mln. Market capitalization on December 6th, 2021: $1 019 000,00 mln. The intrinsic value looks like several orders of magnitude smaller than market capitalisation. Looks risky.

Let’s see the Q3 2021 unaudited cash-flows. Here, I extrapolate the numbers for 9 months of 2021 over the whole year 2021: I multiply them by 4/3. Extrapolated net income for Q3 2021 $4 401,33 mln plus extrapolated amortization charges for Q3 2021 $2 750,67 minus extrapolated capital expenditures for Q3 2021 $7 936,00 equals extrapolated owner’s earnings amounting to $4 401,33 mln. Divided by 1,35%, it gives an extrapolated intrinsic value of $326 024,69 mln. It is much closer to market capitalization, yet much below it as for now. A lot of risk in that biggest investment position of mine. We live and we learn, as they say.

Another stock: Apple. With the economic size of a medium-sized country, Apple seems solid. Let’s walk it through the computational path of intrinsic value. There is an important methodological remark to formulate as for this cat. In the cash-flow statement of Apple for 2020-2021 (Apple Inc. ends its fiscal year by the end of September in the calendar year), under the category of ‘Investing activities’, most of the business pertains to buying and selling financial assets. It goes, ike:

Investing activities, in millions of USD:

>> Purchases of marketable securities (109 558)

>> Proceeds from maturities of marketable securities: 59 023

>> Proceeds from sales of marketable securities: 47 460

>> Payments for acquisition of property, plant and equipment (11 085)

>> Payments made in connection with business acquisitions, net (33)

>> Purchases of non-marketable securities (131)

>> Proceeds from non-marketable securities: 387

>> Bottom line: Cash generated by/(used in) investing activities (14 545)

Now, when I look at the thing through the lens of Warren Buffett’s investment tenets, anything that happens with and through financial securities, is retention of cash in the business. It just depends on what exact form we want to keep that cash under. Transactions grouped under the heading of ‘Purchases of marketable securities (109 558)’, for example, are not capital expenditures. They do not lead to exchanging cash money against productive technology. In all that list of investment activities, only two categories, namely: ‘Payments for acquisition of property, plant and equipment (11 085)’, and ‘Payments made in connection with business acquisitions, net (33)’ are capital expenditures sensu stricto. All the other categories, although placed in the account of investing activities, are labelled as such just because they pertain to transactions on assets. From the Warren Buffet’s point of view they all mean retained cash.

Therefore, when I calculate owner’s earnings for Apple, based on their latest annual cash-flow, I go like:

>> Net Income $94 680 mln + Depreciation and Amortization $11 284 mln + Purchases of marketable securities $109 558 mln + Proceeds from maturities of marketable securities $59 023 mln + Proceeds from sales of marketable securities $47 460 mln – Payments for acquisition of property, plant and equipment $11 085 mln – Payments made in connection with business acquisitions, net $33 mln + Purchases of non-marketable securities $131 mln + Proceeds from non-marketable securities $387 mln = Owner’s earnings $311 405 mln.

I divide that number by the 1,35% annual yield of the long-term Treasury bonds in the US, and I get an intrinsic value of $23 067 037 mln, against a market capitalisation floating around $2 600 000 mln, which gives a huge overhead in the former over the latter. Good investment.

I pass to another one of my investments, First Solar Inc. ( ). Same thing: investment activities consist most of all in moves pertinent to financial assets. It looks like:

>> Net income (loss) $398,35 mln

>> Depreciation, amortization and accretion $232,93 mln

>> Impairments and net losses on disposal of long-lived assets $35,81 mln

… and then come the Cash flows from investing activities:

 >> Purchases of property, plant and equipment ($416,64 mln)

>> Purchases of marketable securities and restricted marketable securities ($901,92 mln)

>> Proceeds from sales and maturities of marketable securities and restricted marketable securities $1 192,83 mln

>> Other investing activities ($5,5 mln)

… and therefore, from the perspective of owner’s earnings, the net cash used in investing activities is not, as stated officially, minus $131,23 mln. Net capital expenses, I mean net of transactions on financial assets, are: – $416,64 mln + $901,92 mln + $1 192,83 mln – $5,5 mln = $1 672,61 mln. Combined with the aforementioned net income, amortization and fiscally compensated impairments on long-lived assets, it makes owner’s earnings of $2 339,7 mln. And an intrinsic value of $173 311,11 mln, against some $10 450 000 mln in market capitalization. Once again, good and solid in terms of Warren Buffet’s margin of security.

I start using the method of intrinsic value for my investments, and it gives interesting results. It allows me to distinguish, with a precise gauge, between high-risk investments and the low-risk ones.

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